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Compound Interest

Updated: Apr 12, 2021

You probably might have heard of interest, but have you heard of compound interest? Today we will be discussing what compound interest is, and how to calculate it.

 

Compound interest is money paid on deposits and loans that duplicates over time. When money is put into an account, the bank will pay interest on your deposit. The reason banks pay interest to you is so that they can loan more money to other people, and if they cannot pay on time then the borrower must pay interest on the loan. The interest paid by the borrower to the bank is then given back to the deposit. It is a cycle between the deposit, lender (bank), and borrower. The main takeaway for compound interest is that the amount of money paid increase as the interest rate remains the same. This may seem strange so let me give you an example. Let's say a deposit is worth $100. The bank pays 5% interest annually (once a year). After one year, without withdrawing money, the value would be worth $105. Now the 5% interest is on the $105, so in the second year the value of the deposit would be $110.25. So basically the amount of money paid increases since the value of the deposit is greater.


Now on to calculating compound interest. The formula is A = P(1+r/n)^nt. These variables each represent a component in compound interest. Allow me to explain what each of them represent. A represents the amount of money after the money is compounded. P is the amount of money you put into a bank account originally. The variable r represents the rate at which the money is compounded. The variable n is the number of times the money is compounded in one year. And finally, t is the amount of years the money is compounded.

Now let's try an example. "An initial deposit of $1487 is put into a bank account. The money is compounded at 2% annually. How much will the deposit be worth in two years?" To answer this let's first organize our information. So P = 1487, r = 2%, n = annually, and t = Now we set up our equation. A = 1487(1+.02/1)^1x2. Once calculated your answer should be around $1547.07.

 

It is important to understand compound interest because it can help your money grow faster. Thank you for reading, please subscribe, and see you next time!


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